How austerity was based on market panic

Markets were full of fear. When that receded, so did the bond spreads.

When countries across Europe were putting together austerity policies in 2011, the orthodox reasoning was that the debt and deficit of the nations were out of control, and that this was being communicated by the markets, in the form of bond yields.

But did nations actually base their estimates of the need for austerity on the fiscal fundamentals? Or were they misled by market reaction? A research paper from Paul De Grauwe and Yuemei Ji breaks down the question.

It's certainly the case that the austerity was based, almost entirely, on the state of the market. The authors compare the extent of austerity measures in 2011 with the spreads of the nations' bonds (the difference between each country’s 10-year government bond rate and the German 10-year government bond rate), and find a near-perfect correlation:

Austerity measures and spreads in 2011

The authors write:

There can be little doubt. Financial markets exerted different degrees of pressure on countries. By raising the spreads they forced some countries to engage in severe austerity programs. Other countries did not experience increases in spreads and as a result did not feel much urge to apply the austerity medicine.

Now, that in itself is not particularly problematic. After all, if the financial markets are rationally responding to problems in the respective nations' finances, then it makes sense to try and calm them by getting finances under control. But if the markets are instead in the throes of irrational panic, then basing policy around their whims is problematic.

Ji and de Grauwe then come up with two proxies to test what it actually was which was driving the financial markets. If the markets are acting rationally, then as fundamentals improve, the spreads should fall. So, starting in mid-2012, they compare the change in debt-to-GDP ratio (just one possible measure of fiscal health) to the change in spread values.

They find that, over the period they're examining, debt-to-GDP ratio increases in every one of the ten nations they study. Despite this, however, the spreads decrease in each — and those decreases aren't particularly correlated with the debt-to-GDP change:

 

Change in debt-to-GDP ratio vs. spreads since 2012Q2

The bond markets don't appear to pay much attention to the basic financial health of the nations. What they do pay attention to is the European Central Bank. The paper states that:

The decision by the ECB in 2012 to commit itself to unlimited support of the government bond markets was a game changer in the Eurozone. It had dramatic effects. By taking away the intense existential fears that the collapse of the Eurozone was imminent the ECB’s lender of last resort commitment pacified government bond markets and led to a strong decline in the spreads of the Eurozone countries.

In the summer of 2012, the ECB removed fear from the equation. What happened then was a widespread collapse in bond spreads. But the collapse wasn't uniform; instead, "countries whose spread had climbed the most prior to the ECB announcement experienced the strongest decline in their spreads". By taking away panic, the ECB lets us see that almost all of the prior variation in the bond spreads had been as a result of that panic.

Basing policy on calm sensible market reactions might work; basing it on the reaction of markets in existential fear probably wouldn't. That's traditionally the time when politicians start trying to lead markets, rather than follow them. And, sure enough, the authors repeat a calculation confirmed by many others: panic-driven austerity has crushed growth in the nations it's been practiced…

Austerity and GDP growth 2011-2012

…and has hurt fiscal fundamentals in those same nations, with debt-to-GDP ratios getting worse the more austerity is practiced:

 

Austerity and increases in debt-to-GDP ratios

The TUC's Duncan Weldon (whose tweets first pointed me to the research) sums up the lessons we've learned:

  1. Financial markets are perfectly capable of acting irrationally. Market panic drove extreme austerity in Southern Europe.
  2. Extreme austerity has proved self-defeating – it means debt/GDP ratios are higher not lower.
  3. Markets, to quote the IMF’s Chief Economist, can be ‘schizophrenic’ – they initially reward harsh austerity measures and then panic when they, predictably, lead to weaker growth.
  4. The end result is that market panic, followed by policy-maker panic, has imposed huge economic and social costs across Europe

Seems like if politicians really really want to base their decisions on the ill-thought-out panic of large numbers of people, they ought to at least wait for an election.

Gambling with out future. Photograph: Getty Images

Alex Hern is a technology reporter for the Guardian. He was formerly staff writer at the New Statesman. You should follow Alex on Twitter.

Photo: Getty
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The future of the left: The path ahead is full of challenges

Be in no doubt: the left faces a struggle for survival.

There are plenty of grounds for pessimism about the left’s prospects and they are well rehearsed.  Across Europe, social democrats are out of power and when they do manage to enter government, it is under the skirts of dominant centre-right parties or at the helm of fragile coalitions. Ageing western societies have become more conservative, immigration has driven a cultural wedge into the cross-class coalitions that once undergirded centre-left voting blocs, and austerity has ushered in a politics of security, not reform. Only those who have borne the brunt of the financial crisis and its aftermath, like the unemployed youth and evicted homeowners of Southern Europe, have swung decisively to the left, joined by relatively protected but angry older middle class liberals of Northern Europe. Even in Latin America, where the left swept the board at the turn of the century, politics is shifting to the right. Bright spots, such as municipal experimentalism in Spanish cities, or energetic liberalism in Canada and Italy, illuminate the gloom. But mostly, darkness is visible.

Is this condition terminal? Inequality, stagnant living standards and the turbulence of global capitalism generate profound political discontent. They give oxygen to progressive protest movements as well as populist reactionaries, as the convulsions in US politics show. But only a facile determinism reads off political progress from economic crisis. There is nothing to guarantee that revulsion at political and economic elites will give birth to a new egalitarianism. The left needs a clearer headed view of the political terrain that it will face in the 2020s.

Demographic change is a given. Advanced democracies like Britain will get older and the weight of older voters in elections will increase, not diminish. The gap in turnout rates between young and old is unlikely to close, tilting politics even further towards the cultural concerns and economic interests of the over fifties. Leadership credentials and economic competence matter for these voters more than abstract appeals to equality. But a generation of young people will also enter middle age in the 2020s having endured the worst of the age of austerity, with lower wages, stymied home ownership aspirations and stunted career progression to show for it. So just as 20th century catch-all parties built cross-class electoral alliances, successful political movements in the coming decades will need to secure inter-generational voting blocs. Stitching these together will foreground the politics of family and focus policy attention on transfers of wealth and opportunity across multiple generations. 

Ageing will also ratchet up fiscal pressures on the state, as costs mount for the NHS, care of the elderly and pensions. But Britain’s tax base has been weakened by low productivity, corporate tax avoidance and expensive personal allowance giveaways. In the 2020s, this crunch will loom large over fiscal policy and force hard choices over priorities. Just as in the 1990s, we can expect public disquiet at the run-down of investment in public services to mount, but this time there won’t be the same spending headroom to respond to it. The political debate currently underway in Scotland about raising income tax is therefore a harbinger of the future for the rest of the UK.

Fiscal constraints will also force the left to take seriously the agenda of economic reform opened up under the ungainly title of “pre-distribution”. Without an account of how to generate and share prosperity more equitably within the market economy, social democracy is purposeless. But it will need a far more robust and plausible political strategy for achieving these ambitions than anything that has been on offer hitherto. Technological change will not usher in a new economy of its own accord, and without the solid base of an organised working class to ground its politics, the left needs to be open to a wide set of alliances with businesses, big and small. Combining economic radicalism with credibility and popular appeal, particularly to voters who still blame it for the financial crisis, is the hardest challenge the left faces, but there is no getting away from it.

On a note of optimism, the left is currently strong in cities, from which it can build out. Diversity is a strength in major urban centres, not a weakness, and powerful city leaders endow progressive politics with governing authority. Cities are the places where new social movements are most active and much of the energy of contemporary politics can be found, even if elections are fought on wider terrain. The task is to combine a propensity to decentralise and devolve with clear national political direction. The same holds with party reform: the mass political parties of the 20th century are dead, but networks can’t fight elections, so combining openness and democratic engagement, with discipline and national purpose, is vital. 

Nick Pearce is the director of the Institute for Public Policy Research.